Term sheet · Explanation

Anti-dilution business question.

Anonymous

December 5th, 2013

Hey folks!

I've got a business question for y'all.

I know allowing preferred stock shareholders to have full ratchet anti-dilution rights is almost always a bad idea, but my question is the following.
Let's say you do allow it and preferred stock shareholders own 70% of your company and 30% goes to common stock, where the company's valuation is, say, $10M. You're about to do a round ... say B. And pre-B, the valuation of the company is now $6M. This means that the common stock shareholders really no longer own anything, but how about that -$1M from preferred stock ... how does it work itself out?

Thanks in advance guys!

- Jonathan

Tony Rajakumar Founder/CEO at SnugBoo

December 5th, 2013

They have no reason to stay at the company - and so they would simply ask the investors for a reasonable stake in the company. The investors at that point would face a choice between seeing the company go to 0 (as it would be worthless without the people - of course assumes minimal IP, etc. - tho keep in mind even with the IP, without the people most buyers would be hesitant to purchase) versus a reduced stake below the $6M in your example. Assuming they're rational, they would pick the latter.

Tony Rajakumar Founder/CEO at SnugBoo

December 5th, 2013

With the common wiped out, the founders and employees have no reason to stay and I'd say the company is thus likely at 0. In other words, the ratchet makes no sense in this context, and the common would renegotiate a reasonable stake. So this is a purely theoretical question I assume? Speaking purely theoretically, if the company's valuation was $7M, then the preferred own everything. Now, if the valuation falls to $6M, it's the same set of shareholders, but the $1M is their total loss.

Steven Vargas Product Manager at Hipmunk

December 11th, 2013

Hi Jonathan,

I don't think that the common shareholders would be completely wiped out, and in fact the Series A would be protected.  Although the full ratchet could severely dilute the original common shareholders, here's how you should be thinking about it:

--------------------------------------------------------------
Series A
    
    Pre-money valuation:  $3M
    Post-money valuation:  $10M
    Investment amount by series A preferred:  $7M
    Total diluted shares:  We can use 10M to make the math easy
     Price per share:  $1.00

    Breakdown of ownership:
           Series A preferred - 70%   (7M shares assuming a straight 1-1 conversion to common)
           Common (ie founders) - 30%

   Note:  Assuming no option pool, so all shares are fully diluted

--------------------------------------------------------------
Series B

   Pre-money valuation:  $6M
             - Note: this is a down round since pre-money is less than previous post money valuation
   
   Investment amount: $5M (to keep the numbers simple)
   Post-money valuation:  $11M

   Additional shares issued:  10M
   Total diluted shares:  20M
   Average price per share:  $0.55
   Series B price per share: $0.50

    Breakdown of ownership before Anti Dilution:
   Series B preferred - 50% (10M of 20M shares)
           Series A preferred - 35%   (7M of 20M shares)
           Common (ie founders) - 15% (3M of 20M  shares)

-------------------------------------------------------------

So, with no antidilution clause, the founders would maintain 15% of their company, and their $3M stake would be worth only $1.65M.

With Full ratchet:
  The series B investors paid only $0.50/share, while Series A paid $1.00/share.  So when the full ratchet kicks in, Series A would get additional shares (which would be created at the financing round) to make up the difference.  In this case, they would get double their shares, or an additional 7M shares.  This would mean that the share breakdown would be:
              Series B preferred:  10M of 27M shares (37%)
              Series A preferred:  14M of 27M shares (52%)
              Common:  3M of 27M shares (11%)

The company is still valued at $11M, so the common shares would be worth $1.22M.  Series A shares would be worth $5.72M, and Series B would be worth $4.10M.

If you've read this far, you can see that there's a problem.  Series B just invested $5M and their shares are worth only $4.10M.  This is part of the protection that the full ratchet gives to Series A.  In reality, Series B would invest that $5M for some % of the company (in this case 50%).  So they would be issued additional shares to get their stake back up to 50%.  This causes a feedback loop, as the Series A would also need more shares since the price per share would suddenly drop.


Anyway, the common do get badly diluted, but the shares are not worthless.  This type of situation is why most term sheets use a Weighted Average anti-dilution.  This is also a reason why common shareholders should not necessarily seek the highest valuation in a round of funding. It may seem great to have your company be worth a lot more, but a down round can trigger some big problems.

Also to note, that when the initial question was framed, the pre-B valuation was $6M.  This pre-money valuation is typically more backed into after the investor decides on an amount to invest and desired %ownership of the business, rather than looking at a company and saying "today it is worth $X and I'll invest $Y)".  This is important because the Series B investors will be looking for a % of the company for their investment that gives them appropriate upside for their risk.  So if there are anti-dilution clauses that are not overwritten, it could drive away potential Series B investors.

Finally, as Tony appropriately pointed out, investors want to keep the common shareholders (ie founders in this case) happy and motivated.  So in the case of a down round, they would not want to dilute the owners to the point where they have no incentive to stay and produce.  If possible, this would mean either giving up equity to the founders or maybe not investing if they think there isn't a compromise that makes sense for both parties.  Of course, and again as Tony eluded to, if the investors are more interested in the IP and technology or the development team, they may not have a problem driving the founders out.

These are reasons why it is important for the founders to not only seek a high share price in the earlier round, but maintain voting rights so that they are not forced into future rounds where they are so badly diluted.

Hope this is helpful and not too involved.  Let me know what you think

-Steve

Anonymous

December 5th, 2013

@Tony Rajakumar:

Thanks for the answer. Yes, this is purely theoretical :) .
I just wanted make sure I understood correctly that the $1M loss would be spread out amongst them.

I have one more question though. You mentioned that the common stock shareholders could renegotiate a reasonable stake ... how would that work? I mean, how can they do that if they're pretty much wiped out?

Thanks again!

- Jonathan

Anonymous

December 5th, 2013

@Tony Rajakumar:

Gotcha ... it makes more sense now.

Thanks Tony!

- Jonathan

Cheryl Tom CEO, Founder at Vain Pursuits

December 11th, 2013

Steve,

Thank you for taking the time to write all that! Very clear, and helpful. 

Cheryl